Virtus Enhanced Core Equity Series
3Q 2016 COMMENTARY
MARKETS — During the third quarter, steadily increasing levels of variability in sector leadership — the persistence of any U.S. equity sector’s performance month over month — added to the challenges that trend-based investment strategies have faced in 2016.
PORTFOLIO — The Series generated a positive return during the quarter. The portfolio’s two main performance drivers diverged during the quarter. The trend-based investment methodology used for the equity portion struggled, while the income portion, which utilizes a systematic option overlay, made a positive contribution.
OUTLOOK — In the current absence of sector leadership, we will continue to implement our strategy with the confidence that the momentum risk factor we utilize, when accessed with discipline, has proven to be of great value to investors over the long term.
During the third quarter of 2016, the U.S. stock market, as measured by the S&P 500® Index, had strong performance, gaining 3.85%. This headline number managed to conceal some interesting market activity that was happening below the surface at the sector level.
One of the metrics that we track is “sector leadership,” which we define as the persistence of any equity sector’s performance month over month. In normal markets, strong performing sectors tend to stay strong for a reasonably extended period of time, and weaker sectors tend to stay weaker. These trends typically stay in place until there is a shift in the macroeconomic environment that the market perceives to have a lasting impact at the sector level.
Thus far in 2016, we have observed steadily increasing levels of variability in sector leadership, with sectors that were leading experiencing sudden and extreme shifts. For example, in July, energy was the best performing of the GICS® sectors; by September it was the worst performing sector. In August, financials was the leading sector; the next month it was the biggest laggard.
This phenomenon is additional evidence of a stock market that lacks conviction. Combined with our prior observations regarding the unusual frequency of “whipsaw” events and the increased “volatility of volatility,”1 the current state of the U.S. stock market is proving a challenge for trend-based investment strategies.
During the quarter, the Series generated a positive return of 3.67% (Class A NAV), as compared to 3.85% for the benchmark S&P 500 Index.
The portfolio has two main performance drivers, and their contributions to performance diverged during the quarter. The equity portion of the Series is invested according to a systematic, relative-strength process, which seeks to identify price trends within the U.S. large-cap equity market. The portfolio overweights those sectors that are deemed to have the strongest positive trends and underweights those sectors with negative trends.
Given the dynamics of sector leadership discussed above, the trend-based investment methodology struggled during the quarter. In particular, the energy sector proved difficult to navigate, as its performance for the quarter was positive overall, but extremely choppy. This variable behavior caused the portfolio’s energy allocation to be out of step with the sector’s upward and downward moves, eventually leading to a -0.50% impact to overall performance.
The income portion of the Fund, which is in the form of a systematic option overlay, contributed about 1% to overall performance during the quarter. This positive outcome was enabled by a largely range-bound market, with limited price jumps, either up or down.
At the end of the third quarter, the Series was tilted towards those sectors showing the strongest upward trends. We have recently seen signs of what may be a narrowing market. Given the lack of clear market leadership described above, we can also imagine that this narrowing trend may reverse itself though.
The income-producing overlay strategy has continued to provide reliable, incremental income without adding exposure to duration or credit risk.
The uncomfortable fact is that the market environment for most of 2016 has not been conducive to any trend-based investment strategy, which has led the Series to underperform the S&P 500 Index. In our experience, it is not possible to predict when risk factors – including the momentum risk factor featured in the Series – will come into or out of favor. In other words, risk factors cannot be market timed. Our strategy is systematic in nature, and we will continue to implement the strategy rules with the confidence that over the long term, the momentum factor, when accessed with discipline, has proven to be of great value to investors.
1 Whipsaw: A large downward/upward move quickly followed by a rebound or recovery; see “The Realities of Whipsaw Risk" by Rampart Investment Management, Virtus.com, November 14, 2016; https://www.virtus.com/market-insights/blog/Rampart/2016/The-Realities-of-Whipsaw-Risk
Class A operating expenses are 0.98% and gross operating expenses are 1.22%. Operating expenses reflect a contractual expense reimbursement in effect through 4/30/2017.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains.
Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.
Index: The S&P 500® Index is a free-float market capitalization-weighted index of 500 of the largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
The investments for the Series are managed by the same portfolio manager(s) who manage one or more of the other funds that have similar names, investment objectives and investment styles as the Series. You should be aware that the Series is likely to differ from the other mutual funds in size, cash flow pattern and tax matters. Accordingly, the holdings and performance of the Series can be expected to vary from those of the other mutual funds. Shares of the separate Series of Virtus Variable Insurance Trust are sold only through the currently effective prospectuses and are not available to the general public. Shares of the VIT Series may be purchased only by life insurance companies to be used with their separate accounts which fund variable annuity and variable life insurance policies or qualified retirement plans. The performance information for the Series does not reflect fees and expenses of the insurance companies. If such fees and expenses were deducted, performance would be lower.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Call/Put Spreads: Buying and selling call and put option spreads on the SPX Index risks the loss of the premium when buying, can limit upside participation and increase downside losses.
Portfolio Turnover: The fund's principal investments strategies will result in a consistently high portfolio turnover rate. A higher portfolio turnover rate may indicate higher transaction costs and may result in higher taxes when fund shares are held in a taxable account.
Fund of Funds: Because the fund can invest in other funds, it indirectly bears its proportionate share of the operating expenses and management fees of the underlying fund(s).
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.